Special Economic Zones and Economic Transformation.The Case of the People's Republic of China

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Economic Transformation

The Case of the People's Republic of China

Dissertation

zur Erlangung des akademischen Grades des Doktors der Wirtschaftswissenschaften des Fachbereichs Wirtschaftswissenschaften

der Universität Konstanz

Eingereicht von Claus Knoth Konstanz, März 2000

Tag der mündlichen Prüfung: 25. Mai 2000

Referenten: Prof. Albert G. Schweinberger, Ph.D. (Konstanz)

Prof. Dr. Carsten Herrmann-Pillath (Witten / Herdecke)

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List of Abbreviations

ASEAN Association of South East Asian Nations

CCP Chinese Communist Party

CEE Central and Eastern Europe

CICT Commercial and Industrial Consolidation Tax

CITIC China International Trade and Investment Corporation CMSNC China Merchant's Steam Navigation Co.

COMECON Council for Mutual Economic Assistance DFI Direct Foreign Investment

DZ Domestic Zone

EPZ Export Processing Zone FDI Foreign Direct Investment FIE Foreign Invested Enterprise

FTZ Free Trade Zone

GDP Gross Domestic Product

GOVA Gross Output Value of Agriculture GOVI Gross Output Value of Industry IMF International Monetary Fund

JV Joint Venture

LDC Less Developed Country MNE Multinational Enterprises

MOFERT Ministry of Foreign Economic Relations and Trade MOFTEC Ministry of Foreign Trade and Economic Co-operation

N.A. Not Available

NIE Newly Industrialised Economy

PR People's Republic

RHS Right Hand Side

SEZ Special Economic Zone

SOE State-owned Enterprise

SZSYB Shenzhen Statistical Yearbook TVE Township and Village Enterprises

UNIDO United Nations Industrial Development Organisation WFOE Wholly Foreign-Owned Enterprises

WTO World Trade Organisation

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1 Introduction

In many developing and transforming countries, foreign capital is seen as one of the key instruments for a faster development or a successful transformation. It is expected that foreign investors provide the much needed capital which is not supplied in sufficient amounts by the underdeveloped domestic capital markets. In addition, foreign investors are assumed to transfer modern technology and western management techniques, increase competition and thereby increase the speed of modernisation and help to get access to markets in industrialised countries. The combination of the foreign capital with the abandoned, often underemployed domestic labour is expected to increase the value of domestic production and to have an overall positive effect on the economic development of the country. Therefore, static effects as well as a considerable influence on the future dynamics of the economy are expected.

The number of countries, opening up to the outside world, switching from an import substitution to an export promotion policy has tremendously increased in the last three decades, especially after 1989 and the disintegration of the Soviet Union. The changes were partly initiated by the disappointing results of the import substitution policy in many developing countries with its limited impact on the economic development of these countries and the very slow rise of the living standards. This policy was especially popular in the 1950s and 60s (Economist Intelligence Unit 1979: 1).¹

The slow growth of these countries and the rapid development of the so-called Asian Tiger countries (Hong Kong, Singapore, Taiwan and South Korea) was the source for a redefinition of the development strategy. It was assumed that there is a positive correlation between the openness of an economy and its economic growth, including the growth of the export sectors and backward linkage effects to other parts of the domestic economy.² The Asian Tiger countries followed an export promotion policy, focussing on the active encouragement of industrial production for export markets, combining an increasing market mechanism with a strong industrial policy. Part of the policy was that trade barriers were lowered and that the countries were opened for foreign competition so that the domestic enterprises were more integrated into the

1 The idea of an import substitution is based on the work of Prebisch (1950) and Singer (1950).

The central assumption of this theory is that the host countries of foreign capital in the developing world are exploited by the foreign enterprises. To avoid the negative effects of the foreign relations, the host country has therefore to restrict and closely to monitor the FDI and to develop its own production base so that a terms of trade deterioration cannot affect the host country. See also Krueger (1985) and Bhagwati (1985).

2 Edwards (1993) gives an excellent summary of the development of the different industrialisation approaches and also discusses the various empirical studies which analyse the interaction between openness of an economy and economic growth.

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international markets.³ At the same time, the political decision-makers influenced the economic process in many respects. Following the fast successes and the positive influence of the export promotion strategy on the domestic development of these economies, developing countries all over the world started to copy this development policy.⁴ At the same time, the oil price shocks of the 1970s and the increase in domestic labour costs made it necessary for enterprises from developed countries to find new ways of reducing their production costs. The location of production units in foreign countries with lower prices is one such way so that the volume of foreign capital that was looking for investment opportunities abroad also increased during this time (Li and Li 1999: 27).⁵

The rising number of opened countries has led to an increased competition among the developing countries in attracting the scarce foreign capital and the developing countries are heavily constrained in this respect. Especially, because most foreign direct investment (FDI) still flows into industrialised countries. In 1998 only 166 of 644 bill. US-$ or 26% (in 1997 37%, United Nations 1999: 361) of the overall annual international investment went to developing countries. Of the 166 bill. US-$, 77 bill.

US-$ were invested in South-East Asia and 45 bill. in China alone (United Nations 1999: 479). A similar picture can be drawn in respect to the inward stocks of FDI. Of the 4,088 bill. US-$ stocks, 1,219 or 30% were invested in developing countries, of which 657 bill. went to south-east Asia, including an accumulated investment of 261 bill. US-$ in China (United Nations 1999: 491). A great surprise was, that China, which was one of the most closed economies when it started its open-door policy at the end of the 1970s, became the second largest host country for FDI in the 1990s after just 15 years, second only to the USA, and by far the largest receiving country among the developing countries.

Because the inflow of foreign capital is not an automatic process, all countries are using different instruments for attracting foreign investors. One instrument that can be found all over the world and which is the central issue of this study are special geographical regions with various incentives for foreign investors.⁶ The number of Export Processing Zones (EPZs), one of the most popular forms of such regions, has

3 A comprehensive discussion of the role of FDI in the Asian economies can be found in Lloyd (1996).

4 Although this positive correlation between export promotion and economic development became the new paradigm of development policy, it was and still is under discussion.

Kavoussi (1985) has shown in one study that most open countries (with the exception of the Tiger countries) have outperformed the protectionist countries in the period 1960 to 1973, but fell behind when the world economy slowed down in the period 1973 to 1977. Singer and Gray (1988) did the same analysis for the period 1960 to 1983 and came to the same conclusion: Their findings support the argument that high growth rates of export earnings occur only when external demand is strong.

5 It is interesting to note that the changed situation not only increased the pressure on the less developed countries to restructure, but the developed countries faced a stronger need to adapt to the changed situation as well.

6 United Nations (1991) proposes the use of the regional approach in Central and Eastern Europe.

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constantly increased and has reached in 1998 over 850 such zones around the world (International Labour Office 1998: 1). The establishment of special geographic areas to reach economic aims is not a new idea. In modern times, larger areas were transformed into free trade zones already since the 18^th century; Gibraltar for example was established as a free trade zone in 1704, Singapore in 1819 and Hong Kong in 1842 (Economist Intelligence Unit 1979: 1).⁷

In all zones, a set of incentives like tax privileges, special infrastructure and simplified regulations are used to attract foreign investors. When China started to open-up SEZs at the end of the 1970s, although such special zones were used extensively all over the world, the concept was all but uncontroversial (Heiers, Schattschneider and Zapf 1988: 166). Three aspects are important in this discussion:

(1) The design of the zone which is equivalent to the selection of one policy mix; (2) The starting point of the host country: industrialised, developing or transforming; and (3) The aims of the host country's government.

In respect to (1) we concentrate our discussion on the Chinese SEZs, which have a number of specific characteristics with special effects. Concerning point (2) we restrict the discussion to transformation economies, which is still a huge field. We will see that SEZs can have functions which are important to transformation economies, but not to industrialised and developing countries. The analysis of point (3), the aims of the host country, will show that a restriction to a small number of aims is necessary and that the zones have to be designed properly according to the aims.

A major difficulty of the governments in transforming countries is the large number of distortions of the domestic economy, combined with only limited political power.

Fast, deep and comprehensive reforms are in such a situation, although they might be necessary, very often impossible, because of the opposition from strong interest groups. If these interest groups are geographically concentrated, the regional policy approach with the establishment of SEZs might be of particular attractiveness for the political decision-maker. The interests of the various groups can be taken into account at the same time. Some opposition also exists against new policies, because people do not have enough information about the potential effects for them. The implementation of new policies in geographically restricted regions can be an information transmission mechanism with a strong demonstration effect. At the same time, SEZs give the government, which lack experience with the reforms, the chance to experiment before policies are implemented in the whole country. This can help to avoid costly policy mistakes. We will argue that this role of SEZs as laboratories is the most important aspect for the zones in China.

7 For the long history of special geographic regions over the centuries see Djumena (1995).

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For example, those regions which have comparative advantages in international trade can open up while the other regions remain behind the old tariff wall.⁸ The tariffs could be reduced step by step later-on or the SEZs could be extended in geographic terms. This is obviously not a first best policy, but SEZs have to be understood as second best instruments, following the approach of Lipsey and Lancaster (1956). As is well known from economic theory, in such a situation the costs and benefits and thereby the welfare effect of reforms depend on the sequencing of the individual policy steps.

In the analysis of optimal policies it is assumed that the political decision-maker can be represented by a single objective function. For transformation economies this is an inadequate simplification. The policy outcome is instead the result of a complicated bargaining process. The distribution of power in the political arena often shifts during the transformation process and the political arena itself is transformed by the development of new institutions and the abolishment of old ones. The development of SEZs can therefore not be understood as the simple implementation of a blueprint which has been developed in the first place. Instead, changes in the political arena and in the overall institutional framework will continuously change the design of the zones. The political economy aspects must therefore be taken into account in the analysis of SEZs in transformation economies.

Ahrens and Meyer-Baudeck (1995: 87) suggest to use the experiences with the Chinese SEZs as lessons for other countries in Eastern Europe:

"[...] special economic zones (SEZs) might be appropriate instruments for accelerating the economic restructuring of CEE [Central and Eastern Europe, C.K.], all the more as SEZs have proved to be driving forces of the systemic change in socialist China. Protagonists of SEZs point out that this instrument positively affects both the economic performance of individual regions and the transformation of the national economy."

This is the starting point of our analysis. We concentrate on the effects of SEZs on the host country during a transformation process.⁹ We analyse in detail the Chinese experiences and in contrast to earlier studies we do not restrict ourselves to Shenzhen SEZ, but look at the development of the four other zones as well. As we will see, this is especially valuable for finding possible negative experiences. This gives the chance to draw important conclusions so that in future policy making this kind of mistakes could be avoided. At the end of the study we are in the position to evaluate

8 This is of course only true in a limited sense. There are many interrelations between the possibilities of the companies which are located in the zones and their behaviour in the domestic market. Very often, there is at least some access to the domestic market so that the domestic firms face some new competition from often superior products.

9 The question, on how far the Chinese reform path has influenced the concept and institutional characteristics of the Chinese SEZs is of course very interesting, but beyond the scope of this study.

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the above proposal to establish SEZs in other countries, following the Chinese experiences. This question is not only of historical interest, because there are still a number of countries, including for example Cuba and Ukraine, which follow or are contemplating about starting such a strategy. The central questions of this study are:

• What are SEZs and how have they developed in China?

• What was their role in the Chinese reform concept?

• How can the political-decision-maker influence the development of the zone, especially the volume of foreign capital inflow?

• In how far can the Chinese experiences be a lesson for other countries?

We will see that in China mainly political reasons were responsible for the establishment of SEZs, but this is not to say that they haven't had enormous intended economic impacts as well. It is noteworthy to see that SEZs as policy instruments cannot be seen independently from the other parts of the transformation and liberalisation policy. They have to be an integral part of the reform policy, including price reform, institutional reforms, macroeconomic stabilisation, privatisation and restructuring, just to mention the main areas. SEZs can only support the transformation of the former socialist countries, they cannot initiate the transformation alone (Gutowski and Merklin 1984: 7).

The analysis proceeds in the following way. After the introduction, chapter 2 defines what is meant with ‘transformation’ in this study and discusses the general role of foreign capital in the development of a country, introduces the concept of SEZs and describes the possible effects of such zones on transition economies.

Chapter 3 summarises those aspects of the Chinese reform policy that are relevant for the understanding of the Chinese SEZ concept. It is at this point not intended to give a comprehensive description of the whole reform process. Instead, only the major steps are presented. The role of the ethnic Chinese investors for the reform process in China is discussed in this chapter as well.

Chapter 4 analyses the domestic and foreign interests in the establishment of SEZs.

For the domestic side, the satisfaction of existing interest groups or the creation of new ones might be especially essential for the government in a transformation country as was already mentioned above. The interests of foreign investors are relevant for the evaluation of SEZs, because the host country can only offer special incentives, but cannot guarantee that they are effective in attracting foreign investors.

Obviously, if scarce resources are used to build up incentives, these incentives should be effective.

Chapter 5 describes the development of the five Chinese SEZs. The chapter contains a large amount of statistical data which has not been discussed in the literature

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before. But only in this way it will be possible to compare the various zones in a serious way. This ends the more descriptive part of the study.

The theoretical part is contained in chapter 6, which concentrates on the existing theoretical models analysing the effects of SEZs on the host country and some extensions of these models are developed. It is examined in how far these models can help to evaluate the SEZs in China and which possible answers they offer and which limitations they have.

Chapter 7 then concentrates on the empirical investigation. Three empirical papers which use cost-benefit analysis methods to estimate the effects of the Shenzhen SEZ are surveyed in section 7.1 and the limitations of this approach are discussed. Section 7.2 concentrates on the linkage effects between the coastal provinces and the hinterland using spatial econometric tools. The open door policy was concentrated on the coastal provinces, but at the same time it was intended to benefit the whole country, especially by the establishment of the SEZs. We therefore look in this section closer at the overall effect on the whole of China. Finally, we discuss some aspects of linkages between enterprises in the SEZs and enterprises in the hinterland (section 7.3).

Chapter 8 then concludes the study by bringing the various parts of the study together to answer the leading research questions stated above. This chapter gives policy recommendations for the establishment of SEZs.

The study shows that the theoretical literature has not faced yet many relevant aspects of real world SEZs. Some small extensions are provided in this thesis, but we make clear that we do not believe that the further development of these models will produce more general insights. Of course, they can be helpful for analysing selected aspects, but they won't help to understand the overall value of SEZs. The analysis illustrates that the example of the SEZs in China is in fact a special one. Because of the complexity of SEZs as policy instruments it is therefore not surprising that there is no simple answer for or against SEZs. Instead, SEZs can have positive effects on the host country, but negative as well. We use in our analysis an eclectic approach, which uses different instruments to analyse the various aspects of the research topic.

We think that this brings us closest to the answering of the above questions.

In total, the following analysis shows that one should not be blinded by the rapid growth of the SEZs in China, especially of Shenzhen, which was transformed from a small village into a huge modern city with a population of more than four million people. The economies of the geographic regions with SEZs have grown with exceptionally high growth rates of sometimes 30 to 40% per year. The establishment of SEZs has the potential for a massive regional growth, but it is essential to ask what the aims of a country are when it uses a limited geographical approach. The political decision-maker has to remember that this kind of a policy instrument does have the

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potential for enormous benefits and for enormous costs. The various aspects of the effects of SEZs as policy instruments are discussed in the following chapters.

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2 Transformation, FDI, and Special Economic Zones

This chapter relates the concept of SEZs to transformation processes as they are analysed in this study and discusses the role of FDI in such a process. To do this we start with a general discussion of transformation processes. We then continue with the discussion of foreign capital and which effects a foreign capital inflow can have on the host country. Finally, we discuss the institutional characteristics of the Chinese SEZs in section 2.3.

2.1 The Transformation Process

Transformation in our context is defined as the process which leads to the fundamental and far-reaching restructuring of an economic system from a centrally planned economy to a functioning market economy.¹⁰ In the general discussion on transformation processes, many misunderstandings could be avoided if the term 'transformation' would be defined in a more precise and used in a more standardised way, which has not been done so far. During the process the main characteristics of an economic system, especially the ownership structure (including defined property rights protected by a functioning legal system which has to be developed), the decision-making process (resulting in an allocation of resources and goods) and the role of the participants in the economic process (individuals and institutions) are redefined. The decision process is being decentralised, functioning goods and factor markets have to be created (prices will then guide the decisions of the individuals), inefficient state-owned enterprises (SOEs) have to be restructured, private enterprises have to be allowed and the institutions of the economic and political system have to be adapted to the needs of a modern, open market economy. The overall role of the state and the state institutions have to be redefined.

Walder (1995: 978) emphasises that the creation of new incentives is a central point in the transformation process, including the incentives for individuals and institutions like the government and the governmental organisations. Lin, Cai and Li (1994: 10) discuss the central role of new incentives in the transformation process in China, how they developed and which effects they had. They come to the conclusion that the new incentives were decisive for the early successes in China's reforms. The countries with a centralised socialist planning system were heavily distorted in any respect and the outcome of the economic process was fundamentally different from the outcome

10 Both, centrally planned and market economies are of course only theoretical concepts, which describe the extreme cases on a continuum of different possibilities. These pure forms of economic systems will never be found in the real world. Instead, mixtures with elements of both systems will be typical. Therefore, transformation in practise means the extension of markets as the mechanism which determines the outcome of the economic process and the establishment of prices as co-ordination mechanism, combined with the establishment of all those institutions which are necessary in a market economy.

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of a market process. The degree of this deviation determines what has to be reformed during the transformation process and how far-reaching the effects of the transformation have to be.

A typical characteristic of a transformation process and its policy making is the limitation in the available policy instruments. In an established market economy with strong and established institutions, realised policies are the result of a more or less clearly defined political process. Interest groups try to influence the formulation of policies, but the influence is limited by the institutions, especially legal institutions.

In a country in the middle of a transformation process, political influence is in transition as well and new political institutions have to be created and old ones have to be dissolved. Howell (1993: 251) emphasises this central point of the reform process:

"Paradoxically, the process of transition from command planning to a market economy still requires a central role for the state. At the political level the state functions to manage new competing and conflicting interests. At the economic level the state steps in to regulate the potential anarchy of market forces. At the same time reform and opening up change the structure and very nature of the state itself."

Ahrens and Meyer-Baudeck (1995: 88) add:

"At the same time, political and economic competences must be properly assigned in order to maintain the ability of political institutions at all federal levels to act, and to have private economic agents act independently within a stable and enduring institutional framework."

The political decision-makers in this situation have to be more careful in their policy formulation, because it is possible that they face strong opposition from the former leading groups, which are going to loose from the reforms and still have enough influence to slow down or even stop the reforms (for the various aspects of government failure in a reform process see Wallis 1998: 42). In addition, the negative effects of the early stages of the reforms on the economic growth can create another constraint for the political decision-maker. Economists who have mainly worked on the transition economies in Eastern Europe came mostly to the same conclusion as Ahrens and Meyer-Baudeck (1995: 87): "[...] it is quite evident that the political authorities are hardly capable of planning and controlling the transition towards the new system, the more so as an economic recession is inevitable in the early phase of transformation". The economic recession has taken place in Eastern European countries, but China has not suffered from this effect in the early years.

China had times of serious macroeconomic imbalances, but never experienced a dramatic decline of the production value. This is partly the result of the remaining control of the Chinese government over the economy, although the decentralisation has passed a lot of the influence down to lower levels of the political hierarchy.

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Another key characteristic and a limitation at the same time for politicians in transformation economies is the need for fast and early successes. The population has already suffered in the old system and it might be willing to trust into promises of future improvements during the so-called 'honey moon' period, but not after long, the people will typically demand recognisable improvements. Sometimes the population even demands immediate improvements of their living conditions. The people are often not willing to accept a longer period of deterioration before the situation might get better. The political decision-makers in transforming countries must take this into account when formulating their reform plan. Comparing the reform experiences of China with those of countries in Eastern Europe support this point. The Chinese reformers choose those areas for their first reform steps, where fast positive changes were easy to achieve. With their fast successes, the new Chinese government was able to gain more support in the early years for their reform policy from most groups in the society.¹¹

The political decision-makers in a transformation economy face the following limitations: (1.) the possible opposition from within the political arena, and (2.) the opposition of the people when they are not satisfied by the results of the reforms. In addition, the reformers have to take the interests of third countries or international organisations (like IMF and World Bank) into account, which can be prominent participants in the reform process. The opening to the outside world and the integration of the country into the world markets can produce a strong impact on the reform in the transformation economies. On the one hand it is the import of a more rational price structure, which might speed up the domestic price reforms and which thereby supports the efficient reallocation of the domestic resources. On the other hand it is the inflow of foreign capital with its expected effects on the domestic economy. Policy changes influence directly the investment decisions of foreigners so that the government has to consider this as well. The membership in international organisations gives a country the chance to commit itself to a specific policy. This can take some pressure from the reform government, because then international organisations can be made responsible for further reform steps.

The ways of policy making have to be changed during the transformation process. In China before the reforms started, ideology and mass campaigns were used to control and to influence the behaviour of the individuals. Part of the development of the socialist states all over the world was the education or indoctrination of the 'new man'. The old ideas and typical behaviour were not compatible with the socialist ideology. Therefore, the thinking and habits of the population had to be transformed in such a way that it would enable the functioning of the socialist system. This was

11 The Chinese reformers were also lucky in so far as they were not as much under pressure to reform as the reformers in other countries in later years. And for them it was also possible to work in an economy which was not as over-centralised as for example the economy of the Soviet Union.

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done with large campaigns. While such campaigns were used in China extensively during the Mao era, a major shift during the reforms was the reduction in the use of these campaigns and the introduction of economic incentives to influence (but not to directly control) the behaviour (Pearson 1991: 26). As Chao (1994: 61) emphasises, the aims of the Chinese reformers were at the beginning quite limited and ex post it should not be interpreted that the government had a very comprehensive reform plan, especially in terms of the political system: "The main idea is to allow market forces to work their magic in helping to lift productivity and economic efficiency without giving up political ideology." For a long time, even after the start of the reforms, the development of a socialist society was the political aim and the use of the market mechanism was only thought of as supporting the development of the socialist system. This has changed in 1993 when the ‘socialist market economy’ was formulated as the new aim and included in the constitution. Although no exact definition of this concept is given, the actual development in China demonstrates that the market-economy part clearly dominates the socialist part of this expression.¹² At the beginning of the reform and transition process, the redistribution of property rights are of great importance and they have to be guaranteed by the government (Krug 1996: 6). The introduction of clearly defined and guaranteed property rights are directly related to the aforementioned incentives. Ownership and the right to decide about the use of the property and of the returns from the property create the largest incentives. Only then are entrepreneurs willing to invest in their ventures. The definition and protection of property rights will also reduce the distortions in the economy. At the same time, a system must be established which allows that resources move out of the non-competitive industries and being employed in the competitive ones - the reallocation process.

The transformation process includes massive changes in the production structure.

Because of the lack of effective incentives, political influences and the limited capacity of the old planning system, the production decisions in the old system did not correspond with the necessities of the new system. Therefore, incentives have to be created which guarantee that the individual firms change their behaviour. The reforms must include on the one hand domestic measures like the reduction in subsidies or the abolishment of preferential access to scarce resources. On the other hand, the competition from foreign enterprises which can be increased by opening the country to the outside world, can be used to induce a restructuring process. In many cases the process of restructuring takes time so that the immediate and full abolishment of the protection might be too radical a change for many domestic enterprises. It can therefore be reasonable to have a transition period in which

12 A very vague definition was given in China Daily (1993): "The socialist market economic structure is linked with the basic system of socialism. The establishment of this structure aims at enabling the market to play the fundamental role in resource allocation under macroeconomic control of the State." (cited from Jakubowicz 1996: 1)

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protection is reduced slowly so that the domestic enterprises are protected from too much competition and have time to adapt to the changed situation (this is of course the traditional infant industry argument of protection).

To create effective incentives for the domestic enterprises to start restructuring, it is essential that the government makes early and clear statements on how long this policy (the preferential treatment in form of protection) will last. The encouragement of joint ventures (JV) with foreign investors are an additional instrument that can help the domestic enterprises to learn about possible ways of reforms or to get direct support in the restructuring from the foreign partner.

One of the main elements of a socialist economy are the state-owned enterprises (SOEs), which dominate the economy. During the transformation process, the role of the state controlled economy decreases and private decentralised decision-makers control an increasing share of the economy. The growth of the private economy as well as the reform of the SOEs, which are in many cases highly inefficient or behave in a way which do not correspond to a market system, are both necessary. As the Chinese experience has indicated, the reform of the SOEs is not necessarily of highest priority at the beginning of the transformation process as long as the private sector gets enough space to develop independently with sufficient access to scarce resources. But the example of China demonstrates as well that the delay of the reform of the SOEs might produce even larger problems in later periods. It has of course to be asked in the analysis of the SEZs whether they can support the reform of the SOEs in the transformation economy and how this could happen.

One way of reducing the weight of the state-controlled industry in an economy is to allow and to encourage the development of decentralised, private agents in the market. This has been done in China and the extremely successful and fast growth of the so-called township and village enterprises (Xiang Zhen Qi Yie, TVES) indicates that in this way, competition can be created endogenously. But this is only a partial solution because the SOEs often succeed in keeping their soft-budget constraint so that they are protected from bankruptcy. This has the effect that resources continue to flow into inefficient production and the distortions create large costs for the society, direct costs as well as indirect costs which emerge because of the delay of necessary reforms.

Another way of reforming the SOEs is to privatise them. But before privatisation is possible, they must be transformed into enterprises which act more like a private company than like a traditional state-owned one and which have the possibility to make a profit. The experiences in Eastern Germany and Eastern Europe have demonstrated the multiple problems of these reforms.

As this discussion illustrates, the transition is a complex process, which involves many different aspects of the whole economy and the whole society in general. It is

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therefore not enough, to look at an individual policy instrument to understand the functioning and the desirability of this instrument. Instead the whole situation has to be taken into account, because the interaction with all other reform policies has to be included. This is one limitation of this study, because it tries to discuss SEZs and their effects in a general way, without looking in more detail on the interaction with other reform steps in China.

2.2 The Role of Foreign Direct Investment¹³

A central reform step for transforming countries is the opening up of the domestic economy to the international markets. Most of the transforming economies were more or less closed towards the world market in the initial situation, only a controlled engagement in the Council for Mutual Economic Assistance (COMECON) was accepted. The opening up, including the increased import and export relations to foreign, non-socialist countries and the acceptance of foreign capital are expected to give rise to a number of benefits for the host country. Foreign capital can help to ease these problems of a limited supply of domestic capital and of the insufficient developed domestic capital markets.

Foreign capital can appear in different forms: foreign loans, portfolio investments and FDI.¹⁴ There are a number of investigations which analyse the question how the role of the Newly Industrialised Economies (NIEs) in East Asia as net borrowers of foreign capital has influenced their development and how it has changed over time (for a discussion see Lloyd 1996: 408).

Foreign loans are needed and used in all countries as can be seen from the statistics of the World Bank and the IMF. But as the debt crisis in Latin America has exhibit, a limit of the indebtedness must not be crossed. Otherwise the problems stemming from serving the loans will be larger than the benefits for the country's development, especially when the existing institutions cannot guarantee that the loans are used in projects with high financial returns so that they make the repayment of the loans possible. The reason for these problems are that many projects (also during the transformation process), especially investments in infrastructure, which are financed by these loans do not have a return which is sufficient for repaying the loans.¹⁵

13 A comprehensive discussion of the role of FDI in economic development can be found in United Nations (1999). For a detailed discussion of the definition of FDI and the various aspects of the problems of measurement see OECD (1996).

14 It has to be emphasised that this classification is under discussion, because the distinction between portfolio investments and FDI seems in many cases to be quite arbitrary.

15 In more and more investment projects to build infrastructure, private foreign capital is playing an increasing role. The foreign investors build the infrastructure and operate it for a specified period of time in which they charge the users of the infrastructure. Finally, the infrastructure is transferred to the host country (the so-called BOT agreements - build, operate, transfer).

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The second kind of foreign capital, the portfolio investment, can also not be used for long-term projects, because it is very volatile and the problems of the combination of insufficient financial institutions and large amounts of portfolio capital became obvious in 1997 during the Asian financial crisis. Portfolio investment has no direct interest in getting control in the running of an enterprise.

Finally, FDI¹⁶ is long-term in nature and the investor has the aim of controlling at least partly the use of the capital in the production process and to be involved in the decision-making process which influences the success of the firm. FDI is part of the internationalisation of the production process through which the various steps of the production are located in different countries. FDI can have a number of advantages for the host country¹⁷:

(1.) The risk of the economic venture is borne by the foreign entrepreneurs (not necessarily alone as in the case of joint ventures). Therefore, they have a vital interest in creating a good performance of the enterprise. As long as the institutional framework guarantees the protection of the interests of the host country (like social issues and environmental protection), the successful performance of the enterprise will benefit the country as well. Distortionary effects of such investments will be discussed later in section 4.5.

(2.) The foreign companies with their needs of higher quality may force through backward linkages domestic suppliers to improve their quality standards and may help them in upgrading their production technology. Thereby domestic suppliers learn about the quality which is needed to be competitive on the world markets. We will come back to this question of backward linkages in section 7.3.

(3.) The engagement of foreign entrepreneurs can have demonstration effects besides the influence on the quality of products. Domestic enterprises observe the behaviour of the foreign enterprises and try to copy their business strategies. The fundamental assumption is that the foreign firms, stemming from more developed countries, possess superior management techniques and better technology. Export-oriented FDI promotes especially the development of the export sector, "local firms may be stimulated to enter the export market by learning from the experiences of the foreign affiliates" (Johansson and Nilsson 1997: 215). Johansson and Nilsson emphasise that

16 As definition of FDI we use the Chinese one: "Direct Investment by Foreign Entrepreneurs refers to the investment inside China by foreign enterprises and economic organizations or individuals [...] following the relevant policies and laws of China, for the establishment of ventures exclusively with foreign own investment, Sino-foreign joint ventures and cooperative enterprises or for co-operative exploration of resources with enterprises or economic organizations in China. It includes the re-investment of the foreign entrepreneurs with the profits gained from the investment and the funds that enterprises borrow from abroad in the total investment of projects which are approved by the relevant department of the government." CSY (1998: 649)

17 For an excellent survey of the possible effects of FDI and a comprehensive survey of the literature see Blomström and Kokko (1997).

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many countries lack the physical preconditions (including machinery, technology and infrastructure) for entering successfully the world markets and that there exists an idea gap, which limits the ability of developing countries as exporters.

(4.) Another effect is the increase in human capital. On the one hand, foreign firms demand qualified workers so that the host country is forced to invest into the education system if they want to attract foreign capital for a longer period of time, and especially high quality FDI. On the other hand, the foreign entrepreneurs themselves invest into the human capital of the employees and provide technical training for the local staff. By working in a western firm, the employees get additional insights into the organisational and technological ideas of the foreign firms. They will transfer this knowledge when they move to another, domestic enterprise.

(5.) The increase in competition which is the result of the entrance of additional, highly competitive firms can support the transformation of the domestic economy and the development of markets. The domestic firms have to find ways to adapt to the changed market conditions. But this is not guaranteed, because it can happen that the foreign firms chose the protected or distorted sectors for their investment, because they have the ability to displace the domestic firms out of the oligopolistic markets and to earn additional rents. This is of course not in the interest of the host country.

(6.) The foreign firms, although they might have privileges in respect to tax payments, will notwithstanding add to the tax revenue of the government (Sun 1996).

(7.) The political decision-makers face numerous demands from the foreign investors, who try to force the domestic government to build a framework which allows the foreigners at least a fair engagement in the host country. One example for this effect is the development of the legal system in China since 1979. Many of the economic laws which were passed were initiated because of pressure from the foreign investors. The development of a legal system then also benefits the domestic enterprises.

In their empirical investigation Borensztein, De Gregorio and Lee (1998) come to the conclusion that foreign capital has the potential to benefit the host country, but that as a precondition a minimum of human capital is necessary to guarantee this. Also a number of theoretical models have revealed that FDI can have positive effects on the host country. But it should not be overlooked that many of these models use very restrictive assumptions and that the use of more realistic assumptions (like different forms of distortions) give rise to the possibility of negative effects of the inflow of foreign capital (see the large literature on immiserising growth). From the statements of politicians from transforming countries, one can get the impression that the inflow of foreign capital in the form of FDI is purely beneficial. It is an open question why

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politicians often set such a high expectation in foreign investors, which is such a dramatic change to the situation in the1950s and 1960s when the scepticism towards foreign capital and especially towards the negative effects of multinational enterprises (MNEs) was dominating (as reflected in the discussion of the Dependencia Theory).

The discussion on the relation between the liberalisation of foreign trade and investment and GDP growth is still continued as Helleiner (1995), Frankel and Romer (1995) and Levine and Renelt (1992) reveals. The hope of a positive effect of foreign capital on the host country is also demonstrated by the publication of the total amount of realised FDI in China. The Chinese government interprets an increase in the volume of foreign capital as a success (and a decrease in the volume or even in the growth rate as a failure). We question this concentration on pure quantity of FDI without taking the quality of the investments into account, but we do not want to follow this problem further.¹⁸

We therefore just assume in our analysis that the host country wants to attract FDI, disregarding the potential qualitative differences in foreign capital. We further assume that this is the result of the objectives of the political decision-maker, though we do not want to go into more detail of the question of the objective function. The interesting question is now which policy instruments can be used to increase the attractiveness of the host country as a location for foreign investors.

We have included this comprehensive discussion of the potential positive effects of FDI, because from our point of view it is crucial not to confuse effects of the SEZs from effects of FDI. If foreign capital does not move into the country because of a SEZ, but only chooses the SEZ as a location then the beneficial effect of FDI cannot be attributed to the SEZs. We will see in chapter 7 that this is one of the most problematic elements of cost-benefit analysis.

2.3 SEZ - Institution and Effects

"In general, SEZs are aimed at promoting foreign trade, diversifying the production of exportables and overcoming structural balance of payments pressures, importing modern technology and know-how, and improving supply conditions on the domestic market. Furthermore, positive employment effects as well as positive spill-overs to the rest of the economy evolving backward and forward linkages are expected."

(Ahrens and Meyer-Baudeck 1995: 88)

18 We see this as an key policy question how the host country's government can influence the specific characteristics of foreign capital inflow like the time perspective and the sectoral distribution. The Chinese government tried to direct FDI in specific sectors, the so-called pillar-industries, by publishing lists of sectors in which foreign investments enjoy special incentives. But it seems to us that the question how and when this kind of incentive can

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This citation illustrates the variety of effects which are expected from SEZs, although from our point of view some effects are not included in this citation. Ahrens and Meyer-Baudeck especially do not mention which role foreign capital plays in all these effects. It is helpful to classify the effects into the following three main categories: (1.) SEZs offer incentives for foreign investors, which increase the expected rate of return so that the attractiveness of the host country relative to other countries increases and the attractiveness of the region with the SEZ relative to other parts of the country. The first effect is positive if the net benefit of an additional inflow of foreign capital is positive. The second effect can either be positive or negative, depending on whether a strong agglomeration effect created positive externalities or induces costs of additional distortions. (2.) SEZs can support the transformation of the whole economy, by direct linkage effects, reallocation effects and through experiments which can be first conducted in the SEZs before they are realised in the whole country. (3.) SEZs can help politicians to stay in power by allowing them to take different interests into account at the same time. The political economy aspects will be discussed in more detail in section 4.1.

These are three focal points of our analysis. For analysing point (1.) it has to be asked why the foreign investors do not come in sufficient amount without additional incentives. What are the main obstacles to them and how can SEZs help to reduce these? As with other subsidies, they may not change the behaviour of the investor only that investors who would have come anyway, like to accept this additional benefit ("taking along effect"). Point (2.) is more comprehensive. Linkages are an influential factor for the transmission of effects from the SEZs to the rest of the country. Without enough linkages, the special zones will only be enclaves generating some income for the home country, but not developing the whole potential. Being able to make experiments is especially relevant for politicians in transforming economies, because they typically do not have experience in this kind of situation.¹⁹ Even foreign consultants are often not of very much help, because the situation is so new that the consultants can base their recommendations only on qualified guesses.

(3.) The political economy point of view is especially substantial in the case of China, because it is the most compelling explanation why SEZs were used in China in the first place. It can give an answer to the question why it is the SEZ approach that the political decision-makers choose to open the country. It must be of special interest for them to concentrate the liberal trade policy on a region. This can be the case if the different regions have different interests in or advantages for international trade.

increase the welfare of the host country needs more in-depth analysis, but this is far beyond the scope of this study.

19 Rhee, Katterbach and White (1990: 6) add as another important point: "FTZ [Free Trade Zones, C.K.] are only a step on the way to implementing a free trade regime for the whole country, but because of limited administrative capacity or other reasons the free trade regime cannot be implemented immediately."

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Pearson (1991) discusses that it is not enough to understand the opening up process as the setting of the investment framework. Instead, one has to look at the bargaining process between the host country and the foreign investors. On the one hand this bargaining process takes place on the national level and translates into the laws regulating foreign investment. On the other hand the bargaining takes place at the firm level as well, which is central in the analysis for China, because the state as joint venture partner is directly involved in the bargaining process as well at both level.

As chapter 6 will reveal, the theoretical models have so far concentrated on analysing the conditions under which SEZs are welfare improving or deteriorating. But these analyses only include some effects which are in our classification under category (1.). Categories (2.) and (3.) are not included at all so that the results have to be interpreted very carefully.

Governments are often willing to bear short term costs of a policy while aiming at long term benefits. Therefore, a negative welfare effect of a short term analysis alone is not an argument against the use of SEZs as a policy instrument, because not all benefits are included in the analysis. This does not mean that the short term analysis is of no use. The results of a short term analysis are still of relevance for the politicians. The political decision-maker will ask how high the costs of a measure are not whether there are costs. He will try to find the best available instrument in order to minimise cost, but as long as the costs are bearable, the government will accept such costs either because it values the long-term effects higher or because the policy can contribute to its own aims (like political support). This is the reason why we discuss a large number of different aspects of the establishment of SEZs so that we can evaluate SEZs in a more general setting.

Internationally, special zones can be classified in the following way:

"A tax-free zone and free ports, which are implemented in order to facilitate (foreign) trade turnover, to improve the refinancing possibilities of enterprises, and to make these areas attractive to foreign and domestic investment;

Import or export processing zones, which favour the production and processing of importables and exportables;

Enterprise zones (zones of free economic activities), primarily established in industrial countries as an instrument of regional policy;

Free banking and insurance zones and technology parks, implemented to increase the international competitiveness of domestic banks and insurance companies and to improve, respectively, the transfer of know- how and the diffusion of technical knowledge." (Ahrens and Meyer- Baudeck 1995: 88)

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2.3.1 SEZs versus EPZs

We will see in the following part that a number of characteristics of these different zones are all combined in the Chinese SEZs. Because the Chinese SEZs are based on the idea of export processing zones (EPZs)²⁰ and to clarify the difference between the two types of zones we cite the following definition of EPZs:

"a relatively small, geographically spread area within a country, the purpose of which is to attract export-orientated industries, by offering them especially favourable investment and trade conditions as compared with the remainder of the host country. In particular, the EPZs provide for the importation of goods to be used in the production of exports on a duty free basis. EPZs are therefore export enclaves within which special economic concessions apply including an extensive package of incentives very often exemption from certain kinds of legislation which do apply outside the zones. Among the most common of such exceptions is that EPZs generally allow the duty free entry of goods for re-export. Within the zone the physical infrastructure and all services necessary for manufacturing are provided: roads, power supplies, transport facilities, low-cost/rent buildings. In a number of cases restrictions on foreign ownership which apply in the country as a whole are waved for foreign firms locating in the zone." (Abbott 1997: 232)

An alternative characterisation of the EPZs is given by the United Nations Industrial Development Organisation (UNIDO) by the following five points (quoted from Chu 1986: 22):

• EPZs are dominated by market mechanisms.

• EPZs are restricted to a limited region.

• EPZs specialise in the production of export goods and offer special incentives for such a production.

• Their major aims are to attract foreign investment, earn foreign exchange and to generate employment.

• Secondary aims are technology transfer, development linkages and the regional development.

Tab. 1 displays the regional distribution of the EPZs which were registered in 1979 and 1997 with the World Export Processing Zone Association:

20 For a description of examples from India, South Korea and Taiwan in the 1970s see Wall (1976).

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Tab. 1: Number of EPZs in Different Regions in 1979 and 1997

Region Number of Zones

1979 1997

North America Central America Caribbean South America Europe Middle East Asia Africa Pacific

N.A.

7 6 5 N.A.

10 19 4 1

320 41 51 41 81 39 225 47 2

China - 124

Total 52 845

Source: Economist Intelligence Unit (1979: 6), International Labour Office (1998: 3)

Tab. 1 indicates that EPZs are a policy instrument which is used all-over the world and which has experienced an impressive increase in the last two decades, increasing from 52 zones to 845 world wide in less than 20 years. The data demonstrates that this kind of zones are by far not only an instrument for developing or transforming countries. Almost half of the zones were located in North America and Europe in 1997.

The number for China with 124 EPZs in 1997 shows that China has opened not only EPZs in the 5 SEZs which are discussed here, but a great number of other zones. For us it is important to see the differences in the concept of SEZs. The following definition of SEZs by Ahrens and Meyer-Baudeck illustrate that many authors do not make a difference at all between EPZs and SEZs:

"SEZs are geographically or functionally limited parts of an economy in which rules and other institutions concerning the production and the distribution of goods and services differ from those in the rest of the economy. These special institutions are realized in order to promote and favour economic activities in a specific area. Generally, they offer both financial incentives, such as lower taxes and tariffs, and subsidies as well as the substantial deregulation of the legal and administrative framework or the provision of legal privileges." (Ahrens and Meyer-Baudeck 1995:

88)

This definition of SEZs is almost identical to the above cited definition of an EPZ with the only difference that the promotion of economic activities in general are mentioned and not specific for export sectors. Following this definition of SEZs would therefore mean that EPZs are a special form of SEZs. In the whole paper, Ahrens and Meyer-Baudeck (1995) sometimes use the term SEZ just for the Chinese SEZs, sometimes they include free trade zones, EPZs and all other special zones in the notion SEZ. The definition of Chao (1994: 63) shows a totally different emphasis:

"As originally envisioned, SEZs were established as development enclaves to be insulated from the rest of China to test the notion of free- market principles in a socialist economy (Leung 1986; Vogel 1989;

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Kleinberg 1990). Firms in these zones are provided relatively free-market environments with minimal government intervention. Foreign exchanges earned through exports can be retained for importing raw materials and new machineries. Private and joint-ventures enterprises are free to hire their own workers instead of having them assigned. They are also free to set wages to reflect market conditions. Bonuses can be awarded to workers for outstanding performances. No central planning is imposed on production with respect to either the type or quantity of products made."

In the following we will see that the Chinese government had a different construction in mind, although the SEZs were based on the idea of EPZs. Already Article 1 of the Regulations of the People's Republic of China on Special Economic Zones in Guangdong Province from August 1980 reveals the major difference:

Article 1 Certain areas are delineated from the three cities of Shenzhen, Zhuhai and Shantou in Guangdong Province to form special economic zones [...] in order to develop external economic cooperation and technical exchanges and promote the socialist modernization program.

[...] (BFAI 1986: 95)

This Article 1 illustrates that the first aim, opening of the country to the outside world is exactly what the other countries had in mind with their EPZs. The technology transfer, the second aim of the Chinese government was not such a clear- cut aim of other governments and the last aim, the support of the transformation process is a new element. From this it becomes clear that the construction of the Chinese SEZs had to be different from the EPZs in other Asian countries. This demonstrates Article 4:

Article 4 In the special zones investors are offered a wide scope of operation, favourable conditions for such operation are created, and stable business sites are guaranteed. All items of industry, agriculture, livestock breeding, fish breeding and poultry farming, tourism, housing and construction, research and manufacture involving high technologies and techniques that have positive significance in international economic cooperation and technical exchanges, as well as other trades of common interest to investors and the Chinese side, can be established with foreign investment or in joint ventures with Chinese investment. (BFAI 1986: 95)

This reveals that the SEZs were much more comprehensive in their construction than the EPZs (see Heiers, Schattschneider and Zapf 1988: 167). They have to be designed in this more comprehensive way, because otherwise their role as laboratories to conduct experiments is extremely limited (Ge 1999: 1269). It was no concentration on manufacturing, but as Article 4 illustrates the investment in agriculture, construction and even tourism was intended as well.

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“Our SEZs not only can develop export-oriented industry, they also can develop labour-intensive industry, they can also develop technology- intensive industries; not only can they develop industry, they can also develop agriculture, animal husbandry, construction industry, and commercial industry. In short, the approach of our SEZs, in comparison to EPZs of the rest of Asia, is much broader.” (Wang and Chen 1985: 21)

Other publications add tourism, real estate, hotels, restaurants, transportation, and communication to this list.

This reflects the aim of the Chinese government that in the SEZs not only production should take place, but that a comprehensive economic structure should develop with all sectors of a modern economy and that the zones have a real population while the labour force of the EPZs typically commute in and out of the zones. Article 4 lays the foundation for linkages between the SEZs and the rest of the country, because joint ventures with domestic Chinese partners were intended so that the basis for a transfer of know-how to other parts of the country would exist. The relationship between the SEZs and the rest of the country are further regulated in Article 9 and 17:

Article 9 Products of the enterprises in the special zones are to be sold on the international market. If an enterprise wants to sell its products in the domestic market in China, it must have the approval of the Guangdong Provincial Administration of Special Economic Zones and pay Customs duties. (BFAI 1986: 95)

Article 17 Investors in the special zones are encouraged to use China- made machinery, raw materials and other goods. Preferential prices will be offered on the basis of the current export prices of China's similar commodities and paid in foreign exchange. These products and materials can be shipped direct to the special zones with the vouchers of the selling unit. (BFAI 1986: 96)

Article 9 indicates that a separation between the SEZs and the domestic zone (DZ) was intended as in the case of EPZs. In the beginning, they were planned as enclaves with only a very limited access to the goods market of the domestic economy. This changed not before 1990, when prime minister Li Peng emphasised at a National SEZ Work Conference that SEZs are more than enclaves (Chan 1991: 11.9). This changed approach is also reflected in the fact that Pudong New Development Area in Shanghai as the continuation of the zone policy, was planned from the beginning in the early 1990s much more integrated with the rest of the domestic economy, which should guarantee a better and more successful interaction. A key difference to EPZs is that in the case of China the domestic market, one of the most attractive aspects for many foreign investors for an engagement in China, was already from the beginning not totally closed for products from the SEZs. The Chinese government limited the competition on the domestic market by permitting only such goods which could not

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be produced by domestic companies or which were under limited supply. Article 17 represents the wish of the Chinese government that through the supply of resources and of intermediate inputs backward linkages would be developed. But this aim conflicts with regulation in Article 13 on the import of production inputs which became one of the major criticisms against the SEZs in China:

Article 13 Machinery, spare parts, raw materials, vehicles and other means of production for the enterprises in the special zones are exempted from import duties. The necessary consumer goods shall be subjected to full or low import duties or exempted, depending on the merits of each case. Imports of the above-mentioned goods and exports of products of the special zones must go through existing Customs procedures. (BFAI 1986: 95)

Because of the poor quality of many intermediate inputs from Chinese production and the unreliability of the supply and because of bottlenecks in the transportation infrastructure, many foreign investors preferred to import the main part of their inputs from abroad (Li and Li 1999: 103). The effect was that only a small share of the total value added was added in China. We will see this in chapter 5 in the trade statistics of the SEZs.

Article 13 includes a main characteristic of Chinese reality by including the sentence

"depending on the merits of each case" in the law. Almost everything, including the taxes to be paid, tariffs, other fees and most other regulations are not applied in every case in the same way. As an effect of the missing of the rule of law all these aspects can be negotiated between the foreign investors and the Chinese side, where the outcome depends on the bargaining power of the foreign investor. For the large enterprises which have an interest in investing in China, the differences in the institutional settings of the SEZs compared to the rest of the country are therefore not as large as one could think from the laws. The status of the investor depends mainly on the investment volume and the role of the chosen sector for the Chinese economy (Bolz, Lösch and Pissulla 1990: 132).